February 3, 2012

The excitement and buzz about the initial public offering for Facebook is amazing. First of all, however, it's important to understand the IPO is not coming out in a couple of days. The company just filed with the SEC last week.

A company does not usually start trading for three to four months after that. So the big question is, If Facebook goes public (we’ll say April 1, hopefully it won’t be an April Fool’s Joke) will it be a good buy or not?

My concern is that many people who buy the stock will look at what they think the stock can do based on price only, and never look at the value or lack of value of what they are buying. People may say that doesn’t matter, that Facebook is a hot issue, and who cares about valuations? The same thing was said back in 1999/2000, and valuations saved me and my clients from losing a lot of money. So, maybe one thinks things are different this time, but is that the emotions talking or is that the brain talking?

First, let me get into why a company does an IPO, and what they want out of it.

The general reason a company does an IPO is to raise capital to expand its business, as opposed to borrowing money. Some companies, and this could be Facebook, will offer a small number of shares to get a value for their business. Any company can say it is worth this or that, but by offering shares it can come up with a true value of what the company is worth.

In the filing with the SEC, Facebook did not list what it is using the funds for, but it will get somewhere between $5 billion and $10 billion. To do the offering, it is primarily using Morgan Stanley and Goldman Sachs, and JP Morgan Chase has also been mentioned.

The job of the offering brokerage firm or firms is to make their client, in this case Facebook, as much money as possible. If they set the price too low and the stock goes up 100 percent after the offering, they cost their client money because they set the price too low. If they set the price too high, investors may not buy the shares and the company will have to lower the price, and again will lose money.

Make no mistake, it is no one’s job or concern after the stock goes public that the investors make a killing on the shares that day. I’ve heard reasonable expectations that the stock will come out somewhere around $42.50. If the stock immediately jumps to $85 even in the next week or so, the issue was underpriced and it cost Facebook billions of dollars. Usually a stock offering can increase 10 percent or so from the offering price, and the company and the brokerage firm is happy.

If the stock goes up too much, be careful. Understand what you’re paying for. Facebook has had some great growth in the past and should have some good growth going forward; its growth is slowing down as it becomes bigger and bigger. In 2010, its advertising grew by 145 percent. In 2011, it grew by 69 percent. And, maybe in 2012, it grows by 35 percent. That's still a great growth number, but not worth buying the stock at a ridiculous price.

Facebook has 800 million users and by summer that number is expected to grow to 1 billion users. The total on the internet is roughly 2 billion, so the growth in users will begin to slow down. Not everyone is going to be on Facebook. A great product or idea will bring in competition — Google has begun to compete with Facebook with its new product Google+. It too is a social media site and it has been growing at a very high rate. Currently Google+ has 90 million users, double what it was just 90 days ago. Google has 350 million active Gmail accounts, but where will Google+ be 12-24 months from now? I don’t know — no one knows — but let Facebook trip up on any small item and there is now an alternative to switch to.

The Bottom line is you should be careful what you pay for Facebook shares. Invest with your intellect, not your emotions.

If you want to buy Facebook, I would recommend you open an account with a discount brokerage firm and use a limit order. I would not recommend placing a limit order much above 10 to 20 percent of the offering price. Don’t let a broker at a big wire house sell you on the idea they can get you a better price for their higher commission. They can’t get you any better price then you can get at a discount house once the stock has gone public.

By the way, if you’re thinking maybe you’ll get a piece of the company before it goes public that day, stop dreaming. There has been talk that the company may want to get something to the users before the brokerage houses. It's not likely that is going to happen. If every user got one share at $42.50 that would equal $340 billion, which is far more than the value of the entire company. The cost of printing and sending all those prospectuses would be enormous. Open your account early, deposit what you want to invest and set your maximum buy price. If you miss it because the stock went wild, forget it and look for another, more reasonable place to invest your money.